Financial Management

MSL 708

Term Project on new project analysis for

RM Industries

Submitted To
Prof. Sonali Jain

Submitted By:
Mudita Mathur 2020SMT6693
Rahul Mundada 2020SMT6708
 Case Description

RM Industries is planning to invest in a special manufacturing system to produce a new product.

The company anticipated the market requirement for the product in the recent covid times and
preferred to consult Ms. Samiksha Sharma, who is an MBA graduate from DMS IIT Delhi and
was hired a few weeks ago as the head of the newly formed Capital Budgeting Analysis.

For evaluation of the investment and check its feasibility the first task of newly formed
department is to perform RM’s Weighted Average cost of capital
New product system on invoice cost is 3,80,000 and system would require 5000 shipping
expenses additional installation cost of 15,000. System follows a modified accelerated cost
recovery system 3-year class with depreciation rates of 33%, 45% and 15% for the first, second
and third year respectively. Company plans to use it for four years and expected salvage value is
40,000 after four years of operational use
RM Industries expected to generate sales of 2000 units per year, selling price per unit for new
product will be 300 per unit whereas cost price will be 200 per unit, excluding depreciation.
Looking at the market scenario due to the pandemic it is projected that both sale price and cost
price per unit will increase by 3% per year due to inflation in the economy. NOWC (Net
Operating working Capital) are willing to increase by 15% of sales revenues to produce new
products and the marginal tax rate is 40%.

The instruction given Samiksha, she immediately started to work on the cash flow calculations
using the data provided by RM Industries to analyze the profitability of the project with the
NPV, simple payback period, IRR, MIRR, and discounted payback period methods and
conducted a stand-alone risk evaluation of the project with different techniques.

Samiksha thought of determining the yield to maturity (YTM) on the RM Industries bonds by
using their current market prices. It is being assumed that no flotation costs in our calculations,
also the company’s current market value capital structure of 25% debt, 15% preferred stock
and 60% equity is optimal. They have about $80,000 in retained earnings this year, which is also
available in cash.
RM’s Industries current market value optimal capital structure:

Data provided by RM’s Industries to be used in the calculation of the cost of borrowing with
bonds:

Data provided by RM’s Industries to be used in the calculation of the cost of preferred
stock:

Data provided by RM’s Industries to be used in the calculation of the cost of common equity:
Step-1: Calculate WACC

Estimating the company’s cost of capital is the first critical and most important step in the
capital budgeting process. Samiksha knows that without this analysis, it would not be possible
to determine if the new system planned for the investment would be a profitable investment
for RM Industries. From the above input she has been able to calculate YTM, Cost of Preferred
Stock, CAPM, Discounted Cash Flow Rate, Own-Bond Yield-Plus-Risk Premium, Cost of
retained earnings, Cost of new common stock. Now she decided to calculate the Weighted
Average Cost of Capital (WACC) using all the values defined above for the organization.

Samiksha calculated the Weighted Average Cost of Capital (WACC) for investing in a special
manufacturing system to produce a new product will be 9.52%.

Step-2: Cash flow calculation

Samiksha collected data from sales and accounting department of unit sales, cost of
manufacturing system and using that she calculated the net cash flows in 4 years horizon as
shown in below table:
Cash flow has been calculated considering cash flow due to net working capital which is taken
as 15% of sales with addition of CFAT, depreciation, salvage value & tax rate
Step 3: Evaluate the Profitability of the Project

Net Present value and IRR are the methods used in evaluation of projects,
The major difference between the NPV and IRR methods is mainly ascribed to the different
reinvestment rate assumptions of intermediate cash inflows accruing from projects.
The IRR method implicitly assumes that the cash flows generated from the projects are subject
to reinvestment at IRR.
In contrast, the reinvestment rate assumption under the NPV method is the cost of capital. The
assumption of the NPV method is conceptually superior to that of the IRR as the former has the
virtue of having a uniform rate which can consistently be applied to all investment proposals.

Simple Payback Period

NPV: $123034.028
IRR: 19.9%
Simple Payback Period: 2.86 years
Discounted Payback Period: 3.33 years
The NPV technique is more reliable and superior to the other techniques of capital budgeting.
Assumption of reinvestment rate in NPV method is more realistic compared to IRR method
The NPV is positive which is good sign that the project will give some return in four years as
considered, IRR and simple payback period results all look promising

Step-4: Stand-alone risk analysis of the project with the sensitivity analysis with some
assumed scenario analysis

Samiksha decided to conduct a risk analysis of the project before the company decided to go
ahead with it. There may be a high probability that the new product will be similar to the
company’s other existing products, the new project will not change the RM’s Industries product
structure and its overall market risk, Therefore Samiksha suggested that it should be sufficient
to evaluate the stand-alone risk analysis of the project.
She learnt various techniques for calculating risk analysis and decided to go ahead with
Sensitivity analysis as it is used technique to determine to what extent a project’s NPV will
change with respect to a given change in an input variable. Input variables such as sales or the
cost of capital are often used and other variables are kept constant.

Following assumptions are made for calculating the risk-analysis

Assumption 1: Forecasting of sales is very difficult with high accuracy, hence Samiksha
evaluated the impact of 10% increase or a decrease in sales and cost from their base forecast.
We can also conduct a sensitivity analysis for the project’s NPV with regard to a 10% deviation
from our base sales forecast.
Here CV is 4.67 which is on higher side so in this scenario project is riskier, although NPV looks
promising

Assumption 2: Given the current volatile financial environment, the actual WACC figure is also
likely to deviate from the expected base level. Samiksha decided to know how sensitive the
project’s NPV is to an increase or decrease of 1% in the WACC. For this she remembers another
technique called Scenario Analysis, In this technique, the best vs worst case NPV are compared
with normal NPV

Here CV is 12.533 which is very higher so in this scenario project is at higher risk still NPV is
positive
Samiksha decided to take combination of above two scenarios to get better understanding of
risk analysis so she come up with following assumption

Assumption 3: Samiksha decided to try another technique called Scenario Analysis. In this
technique, the best and worst case NPV scenarios are compared with the project’s expected
NPV.
As the best-case scenario, she assumes that the WACC will be 1% lower and the sales forecast
will be 10% higher than our original estimates. For the worst-case scenario, assume that the
WACC will be 1% higher and the sales forecast will be 10% lower.
Here CV is 3.53 which is comparatively better compare to earlier scenarios still CV in this case is
on higher side so it indicates that project is riskier but NPV for scenarios is positive so we can go
ahead with project

Conclusion
After conducting above analysis, Samiksha concluded that NPV, IRR, payback period looks
promising in all scenarios taken, although CV is on higher side, she suggested to go ahead with
project to RM industries